Rare earth minerals have no substitutes and are crucial for the production of high-tech products, including advanced batteries, cell phones, flat-screen televisions, hybrid vehicles and military weapons, such as radar and cruise missiles. China controls production of 97 percent of the world’s rare earths.

Recall the Chinese, though they deny it, used the suspension of rare earth exports to Japan as negotiating leverage to win the release of the fishing boat captain who had been detained in the East China Sea. This alarmed many countries and companies, who are completely dependent on supplies from China.

Even before the current action, Paul Krugman wrote in Sunday’s NY Times,

Then came the trawler event. Chinese restrictions on rare earth exports were already in violation of agreements China made before joining the World Trade Organization. But the embargo on rare earth exports to Japan was an even more blatant violation of international trade law.

Oh, and Chinese officials have not improved matters by insulting our intelligence, claiming that there was no official embargo. All of China’s rare earth exporters, they say — some of them foreign-owned — simultaneously decided to halt shipments because of their personal feelings toward Japan. Right…

Couple the rare earth story with China’s behavior on other fronts — the state subsidies that help firms gain key contracts, the pressure on foreign companies to move production to China and, above all, that exchange-rate policy — and what you have is a portrait of a rogue economic superpower, unwilling to play by the rules. And the question is what the rest of us are going to do about it.

This latest move significantly escalates a steady increase in economic and trade moves by both countries. If confirmed, the Obama administration might have no choice but to reply with some similar action, particularly given the poisonous mid-term election atmosphere in the United States.

Some Chinese officials are out tonight denying the report as “groundless” and that no such measures will be implemented. We’ll see how the rare earth stocks react to the news.

Nevertheless, the original report in the NY Times cited industry officials that the rare earth embargo is expanding beyond Japan and has prompted the U.S. Trade Representative office to investigate the allegations. This is political dynamite in Washington,

“We strongly support USTR’s investigation into whether China is blocking exports of critical minerals to the U.S.,” said Rep. Sander Levin, D-Michigan. He is also the chairman of the House Ways and Means Committee.

“If China is found to be blocking shipments of these critical minerals in retaliation to the U.S. investigation … of Chinese practices regarding green technology, then China’s blockade would require the U.S. to immediately challenge these actions as WTO inconsistent,” he added.

Given China’s conflicting signals and their past history of denial, we don’t think this story should be so easily dismissed. The markets surely have not priced it and one only has to look at the massive sell-off in Chinese solar stocks since last Friday’s announcement by the U.S. Trade Rep to get a sense of how it will play out. We have elevated a potential trade war as a major market risk. Let’s hope China’s interest rate hike is a prelude to a similar surprise move on the exchange rate, which would relieve much of the bilateral tension.

If the rare earth story is true: (W)hiskey (T)ango (F)oxtrot are the Chinese thinking? Is there a power struggle taking place in Bejiing?